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2 for 1 Stock Split: What Does It Mean?

Plenty of our readers have asked us: “What exactly is a stock split?” Here’s what you need to know.

In the world of finance, isn't more always better? Though the answer might seem obvious at first, the reality isn't necessarily so clear -- especially when it comes to stock splits.

What exactly is the definition of a stock split? Generally speaking, it's when a company increases (or, in the case of a reverse split, decreases) the number of shares of common stock it has outstanding in a fixed ratio. On the surface, a stock split changes the calculation of earnings per share, and little else. However, the reality is somewhat more nuanced.

Here are a few well-known companies that have engaged in stock splits in recent years.

Each of these businesses split its stock for different reasons, so let's dig a bit more deeply into the rationales that drive these maneuvers.

Increasing liquidity?

There are numerous reasons why a company might choose to split its stock, but some apply far more commonly than others. Perhaps, the most frequent genesis of a stock split is to provide investors with added liquidity by lowering a company's share price. Here, Starbuck's April 2015 stock split -- its sixth as a publicly traded company -- serves as a useful example.

At that time, Starbucks split its stock 2 for 1, cutting its share price in half from about $95 to roughly $48 on the theory that this would make it easier for retail investors to purchase shares in the company, thus increasing its liquidity. In fact, CEO Howard Schultz specifically cited added liquidity as a rationale for the move in the press release announcing the move. "This split is a direct reflection of the past seven years of increasing shareholder value, enhancing the liquidity of our shares, and building an attractive share price," he said.

There is mixed evidence suggesting that stock splits help spur short-term rallies in share prices, and some attribute such results in part to the increase in liquidity.

More exotic reasons for splits

Image Source: Getty Images

In mid-2014, tech giant Apple announced it planned to split its stock, giving existing shareholders seven shares for every one they owned. Though it never expressly said so, its motivation appeared to be to lower its share price in order to position itself for entry into the vaunted ranks of the blue-chip Dow Jones Industrial Average index.

For context, the Dow Jones Industrial Average is a price-weighted index, meaning each component company's strength in it is determined by its share price; stocks with higher prices have a greater effect on the Dow's daily movements. At its pre-split share price of roughly $645, Apple would have been far and away the costliest equity in the Dow, giving it too large a sway over the index's behavior.

The split gave Dow Jones the ability to add Apple to the prestigious index without having the tech company overpower it -- and it did so in mid-2015.

Not all companies with high-cost shares choose to engage in stock splits, though. Here, Warren Buffett's Berkshire Hathaway stands as one of the most commonly cited examples. Though it created and has split its Class B shares for some complicated reasons (primarily involving a major acquisition), Berkshire has famously never split its Class A shares, which carry substantially more voting power. Buffett's thinking on the subject is simple. As he explained to his biographer Alice Schroder, "I don't want anybody buying Berkshire thinking that they can make a lot of money fast... They're not going to do it, in the first place. And some of them will blame themselves, and some of them will blame me. They'll all be disappointed."

This speaks to a broader truth -- namely, that stock splits don't alter anything at the company level. They only increase the numbers of slices in the earnings pie; they don't grow the pie itself. So while they can create temporary gains for investors, stock splits are better viewed as one-off events that don't necessarily improve or diminish the underlying quality of a company.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Andrew Tonner owns shares of Apple. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Apple, Berkshire Hathaway (B shares), and Starbucks. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.